Trading Options On Smith & Wesson: Still Running On A Full Metal Jacket

| About: Smith & (SWHC)

When I hear the term "full metal jacket," the first thing that comes to my mind is the 1987 movie that was directed and produced by Stanley Kubrick. The term "full metal jacket" actually refers to a lead bullet that is covered with a jacket of tougher metal, typically copper. With the winning streak that Smith & Wesson (NASDAQ:SWHC) has seen this year, investors may wonder if the stock still has any ammo left. Can Smith & Wesson continue to blow away earnings estimates?

Shares of Smith & Wesson have been on an amazing run this year, bringing shareholders a year-to-date return of over 125%. During the course of the year, I have showed investors how to trade Smith & Wesson for less using deep in the money calls as an alternative to stock ownership. Not only has Smith & Wesson been good to shareholders, but also to option traders speculating that increased demand for guns will continue to drive earnings higher. For a look back at previous articles please click here and here.

Chart forSmith & Wesson Holding Corporation

Smith & Wesson last reported Q1 2013 earnings on September 6, 2012, that produced another earnings surprise. This is actually the second time in a row that Smith & Wesson had a blowout quarter that resulted in a positive earnings surprise, with Q4 2011 EPS at 0.27 (0.17 estimate). Smith & Wesson reports earnings the week of December 10th and for investors that are still bullish on the company, I believe one of the best ways to trade Smith & Wesson is using deep in the money calls.

There are many reasons why investors want to use deep in the money calls as a substitute for buying stock, but for myself I prefer to use this strategy on companies that I am bullish on as a cheaper alternative to buying stock. There are many advantages and disadvantages to using this strategy, and for more information please click here. In the last article that I wrote about Smith & Wesson, I brought up the NCIS (National Instant Criminal Background Check System) and how increases in background checks can be a primary indicator to measure how many people want to purchase a firearm. When taking a look back at the last NCIS release (November 30, 1998 to August 31, 2012), investors will notice that December has been the biggest month for background checks every year since 1998 (except for 2008 where November slightly edged out December).

As the holiday season comes closer, there will probably be more attention placed on large internet and brick-and-mortar retailers. In my opinion, Smith & Wesson could get lost in the shuffle. At first glance, firearms may not seem a popular choice as a gift for someone this holiday season, but in actuality, firearms continue to bring strong sales for Smith & Wesson during the holiday season. Last year's Black Friday showed a record number of background checks in a single day at 129,166. With this year there being a presidential election, I would expect to see another record number, as there is always the possibility that new gun legislation could put limitations on gun ownership. Handguns are also becoming increasingly popular, as sales increased 38.6% or up 20,739 from last year. Lower priced smaller weapons (handguns and revolvers) have women buyers on the rise and their portability, flexibility and lower price points tend to drive in more first time gun owners. Smith & Wesson's popular selling M&P Shield currently ranges from $449 to $469 and still has a decent resale value compared to other items that are bought during the holiday season that lose their value. With earnings being a key driver for Smith & Wesson's share price going higher, I believe Smith & Wesson can continue to operate with a full metal jacket for the following reasons:

1) Smith & Wesson has a strong consumer market where the last three months of the year are typically the busiest for the company.

2) The fundamentals still remain strong for Smith & Wesson, as the company reported its backlog continues to grow. Despite some concerns about the slight decline in the backlog, this was the smallest % decline in the last three years of its backlog.

3) Financial outlook is continuing to rise, with Smith & Wesson raising full year 2013 guidance. In Smith & Wesson's earnings, the company has almost doubled its profit from 2011 by more than 50% on a GAAP basis.

4) With strong cash flow and the increase to overall cash, Smith & Wesson spent some of this extra cash to bring down debt, by repurchasing some of the senior debt.

5) Operating expenses (from last earnings report) have been reduced from the same period last year, and I would expect with Smith & Wesson entering a busy period for gun sales that these expenses could increase, but still be manageable with positive results.

6) With the busy period for gun sales coming near, Smith & Wesson has been continually trying to meet demand by strengthening capacity in its facilitates by utilizing improvements in equipment and technology.

With the busy period coming soon for gun sales, I would consider the December $8 deep in the money calls on Smith & Wesson. I wouldn't want to be a buyer right away, but would rather wait for a pullback and buy at a cheaper price. Typically after earnings, Smith & Wesson does have a tendency to pull back/ trade within a range and with the current Dec $8 going for around $3.00, I would be patient and wait for a cheaper price. With Smith & Wesson at year-to-date highs, I believe the stock will give you some chances to buy on dips. One of my goals with deep in the money calls is to achieve the lowest breakeven point as possible to increase probability of success. While a low breakeven point does not guarantee success, this can help traders get to their breakeven point faster and have plenty of time to decide if they should take profits or hang on. With the presidential election right around the corner, traders should also pay close attention to any negative rhetoric concerning guns/gun laws since this could have a negative effect on the stock, which has a beta over one.

In conclusion, I am expecting Smith & Wesson to continue to deliver strong results as the outlook for guns continues to remain strong. Despite the fears over what the presidential election will mean for gun makers, the high beta, and investors wondering if there is more room to run; Smith & Wesson continues to operate on a full metal jacket.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SWHC over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Will be considering the Dec deep in the money calls on SWHC soon.